Leveraging futures vs. ETN differentials

August 22, 2013 07:00 PM

The relatively smooth price trends for gold, silver and copper futures that were in place when 2013 began were interrupted by rough waters in mid-February. As you can see in “Futures price changes” (below), values fell abruptly in the middle of April. The metals showed signs of modest recovery by the end of the month, but that process has been slow to develop.

Metals exchange-traded notes (ETN) followed much the same course as the futures contracts through the first four months of 2013. “Metals ETNs veer from futures” (below) shows that although the overall patterns of price changes are similar, there are significant differences between the ETN and futures markets.

For example, the cumulative percentage price change for the silver ETN (USLV) fell to negative 95% on April 16 as opposed to the cumulative change of –30% for May 2013 silver futures. This difference is not surprising for an ETN that has the objective of providing three times the daily performance of the S&P GSCI silver index, plus a daily accrual of three-month U.S. Treasury rates (less the daily investor fee). In other words, leverage may be sought for price gains or losses, and it is obvious that the leverage is working as intended.

The gold ETN (UGOLD) also is leveraged, and has the goal of producing three times the S&P GSCI gold index. At the end of trading on April 16, 2013, the cumulative percentage price change for June 2013 gold futures was down by 19% compared to –68% for the gold ETN, again demonstrating the power of leverage. 

Copper futures and the contract’s comparable ETN do not show the same results as gold and silver. The operative copper ETN is iPath DJ-UBS Copper TR Sub-Idx. The note has the objective of reflecting the performance of copper futures contracts traded on the CME’s Comex and is not leveraged. While the May 2013 copper futures fell to a –14.30% cumulative change on April 16, the copper ETN had declined by 14.96%. 

For a trader interested in gaining from leverage and willing to accept the risk, silver futures and silver ETNs are prime alternatives.

Leveraged opportunities

“Metals call options” (below) shows June and December delivery dates for silver, gold and copper futures on April 16, 2013. The three higher price curves for December (square symbol) have silver above copper and gold because of silver’s acceptance by the options market as the most volatile and, thus, the most valuable option of the three calls having the same expiration date. For June calls (triangle symbol), silver is still the highest curve, reflecting its superior volatility. While copper has given up its position relative to gold, the two price curves are almost equal. 

Heights of options price curves, as measured by the ratio of the call value at the point where the futures price is equal to the strike price, indicate the options market’s assessment of relative (implied) volatility for each futures contract. For the calls on silver, gold and copper, the curve heights for the December expiration are 8.77%, 6.34% and 7.18%. For June futures, they are 5.19%, 3.76% and 3.12%. 

The call price curve heights are determined by the spread between upper and lower breakeven prices (at which a neutral delta spread will return neither profit nor loss at expiration). According to the options market’s forecast on April 16, 2013, December breakeven prices for silver, gold and copper are $29.64-$20.61, $1,657.28-$1,257.62, and $3.88-$2.91, respectively. These price ranges compare with the December futures prices on April 16: silver, $23.665; gold, $1,378.40; and copper, $3.34. As always, the options market does not forecast a direction of price change. It only cares about volatility and time to expiration in determining call and put prices.

Descriptions of the gold and silver ETNs indicate that they are an easily traded pair, priced as exchange-traded securities not too far apart in dollars and cents.

After slowly gaining with respect to silver over the first three months of 2013, UGLD plunged by $13.03 from April 9 to April 16, while USLV fell $8.64. Gold has led the recovery from that short-term trough, rising by $4.78 vs. $1.23 for the silver ETN through April 30. Based on past experience, silver eventually should narrow its price spread with gold; however, at the end of April 2013 this had not occurred.

The copper ETN DJ-USB is not leveraged but is based on an index of copper futures contracts. On April 30, 2013, the index consists of one futures contract on copper, currently the high-grade copper futures contract traded on the Comex. The ETN is balanced with copper futures by dollar weighting. This creates the possibility of a shadow price in the same way that the COW agricultural ETN was shadowed by a combination of agricultural futures contracts (see “Trading cattle, hogs and ETNs,” November 2012).

A chart of cumulative percentage price changes for May copper futures and the copper ETN would illustrate how closely their prices move together, with apparently little chance for a profitable spread trade between the two. However, we will look at the daily differences in percentage price changes between the futures contract and ETN to investigate trading potential.

As shown on “Differences in percentage price changes” (below), there are many one-day shifts between plus and minus differences from Jan. 3 through April 30. Because the bar chart shows changes in the futures price less changes in the ETN, a positive difference means that neither a negative nor positive change in the futures price could overcome a larger negative shift in the ETN. Counting on the possibility of a one-day reversal, this suggests buying the ETN and selling the futures contract to hedge and to help provide funds for the ETN purchase.

On the other hand, a negative difference means that a change in the ETN price could not overcome the negative change in the futures price. Thus, the indication would be to buy the futures and sell the ETN to cover the trade.

From Jan. 3 to April 30, 2013, there are 11 dates on which the difference in percentage changes exceeds 40 basis points (0.40%). In eight of these, the difference is positive (buy ETN, sell futures), with three dates showing a negative difference (sell ETN, buy futures). 

Results for the 11 spread trades are summarized on “Spread profit: Copper futures vs. ETN” (below). In each trade, 2,500 ETNs are spread against one futures contract of 25,000 pounds of high-grade copper. This ratio generally produces a net one-day investment of approximately $20,000.

Of the 11 spread trades, eight are profitable, with the highest return being April 16-17 at $1,325. Two trades show losses ($150 April 25 and $200 April 30). One trade, resulting in no gain and no loss, occurs on the weekend of the big shake-out in metals prices, April 12-15. Because of the large dollar amounts swinging both ways on this date, it appears that the market was able to counteract possible losses in either direction. Futures and ETN price charts described earlier indicated that huge gains and losses were at stake at this mid-April event, from which the metals are still recovering.

Are the profits on these trades realistic? To a certain extent, the results are hypothetical and depend on actual market prices reflected in end-of-day numbers. Actual trading results could vary significantly from those shown here. It also is surprising that a positive dollar amount could remain for retail trading following arbitrage between ETNs and futures.

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com. 

About the Author

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.